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Zynga's Rise And Fall?

|About:Zynga (ZNGA)

Social media games and apps have become very popular over the last few years. Due to the generally cheap cost of producing an app, especially with a small team coding on their off hours after work, led to quite a few success stories. One of the biggest, Zynga (NASDAQ:ZNGA) is well known for its large success with Farmville and Cityville. With earnings estimate of 6 cents per share and reported earnings of 1 cent a share, the disparity has caused it to be trading down 37% in after hours trading, from around $5 a share to $3.20 a share as of this writing.

With that said, we can look into the apps a bit more. Farmville started in 2009 and is exactly what it sounds like. You run a farm. I've played it for a bit and it consists of building a farm, rearranging chickens and planting and harvesting crops. I lost interest pretty quickly, but many of my friends (notably my female friends) were addicted to it and constantly checking the growth of their crops. It boggled my mind, but they seemed to love it. But it lacked 2 items necessary for the long term survivability of the game. There was no depth to the game and lack of community. No matter how cute the chicken and cows are, you can only plant strawberries so many times before enough is enough. From April 2011 to May 2011, active daily users dropped from 13.5 million to around 12 million. This may have been a continued result of the rise of Cityville which started in December of 2010, but the loss of users was inevitable.

Cityville was a much bigger success than Farmville. It reached upwards of 20+ million daily active users, but with the same issues and same situation, it has slowly deteriorated over time and is current sitting around 3.5 to 4 million daily active users.

With all the money in the bank and no other hit games, they began acquiring smaller startup firms with promising games. One notable purchase was Draw Something by OMGapp. Draw Something is a pictionary type game that you could play with friends online. It exploded onto the mobile gaming platform and grew quickly to over 15 million active daily users in just a month or two. When I first heard about it, it was fun, but after about a week or two I started losing interest. I tend to have a much shorter attention span than most people, so I would assume that people would play the game much longer. Once Draw Something reached 15 million users, it was bought out by Zynga for a pretty price tag of 200 million. Then immediately in the following month, it lost 5 million active users. This is attributed to the game itself. You earn coins by guessing the picture correctly, but the database of items to draw is limited and starts to repeat quite often unless you buy the app for 1.99. The issue is, people like free stuff. 1.99 isn't much, but people are attached to free. So you either, increase the amount of items to draw for free, thus lowering your income as less people will purchase the app, or leave the app at 1.99, but then losing all the players who are unwilling to pay for the additional drawing items. It is a fine balance that was missed.

Going back to their earnings report. You can see from their income statements that gross income has risen quite exceptionally and their gross profit is well in line with their total revenue growth with economies of scale. Once the game is created, the cost of adding additional servers/maintenance for their games is marginal compared to the additional amount of users they can support.

The issue is that their R&D (research and development) and SG&A (selling, general & admin) expenses have shot up out of proportion to their increase in revenues.

Looking at 201o to 2011, revenues roughly doubled, cost of revenues doubled resulting in double the gross profit. So far so good. Once you move down more, you see R&D and SG&A has more than doubled. So that all the profit is used up, leaving very little for shareholders. This results in very little earnings per share.

(click to enlarge)Click to enlarge

(Information for this chart was taken from the Edgar/SEC database)

While Zynga has been great at attracting users, if they are able to keep and grow their user base even at a low growth rate, but optimize their R&D and SG&A, they could become quite a profitable company.

With that said, we have no intention of investing in Zynga as we have not done enough homework (just taking a quick look at a few income statement is nowhere near enough) and it does not seem to trade at a big enough discount, assuming we could value the stock fairly.

Lodestone Blog

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Stocks: ZNGA